That unfranked distributions (other than distributions within a
consolidated group) between resident entities (including trusts and companies) be taxed in
the recipient entity's hands.

In A Platform for Consultation -- see Overview (page 54) and
Chapter 15 (pages 349-355) -- the Review canvassed three options for treating
entity distributions so as to achieve integrity through the entity chain. The three
options were to:

 impose a deferred company tax;

 apply a resident dividend withholding tax; or

 tax unfranked inter-entity distributions.

Each option would help address the unintended loopholes created by the way the existing
section 46 rebate frees from tax most unfranked dividends between entities as well as
the added complexity of the wide range of associated and other specific anti-avoidance
provisions relating to the availability of the section 46 rebate.

Distributions between entities within a consolidated group would not be affected by any
of the options. Under the consolidation regime (see Section 15) all intra-group
distributions will be ignored for tax purposes.

Despite simplicity and compliance advantages, the main problems with the deferred
company tax would be the adverse impact on reported after-tax profits of the distributing
entity and the impact on non-portfolio distributions to foreign investors. While the
proposed accompanying company tax/dividend withholding tax (DWT) `switch' would generally
have improved the position of portfolio investors under deferred company tax,
consultations suggested that credits for deferred company tax relating to non-portfolio
investors may only add to excess foreign tax credits. In addition there is uncertainty
about acceptance of the switch by foreign jurisdictions.

Resident dividend withholding tax and taxing unfranked inter-entity distributions are
similar to each other in that they would have no impact on reported after-tax profits of
the entity making unfranked distributions. They would also have similar effect through the
entity chain in that they impose tax on the entity that receives an unfranked distribution
(although the impact may be different where the member's investment is geared -- that is,
when taxing unfranked inter-entity distributions, no tax will be paid if there are
sufficient deductions to offset the distribution, yet under the resident dividend
withholding tax, the tax will have already been withheld). Both options would also apply a
non-resident DWT - generally at a 15 per cent rate - to unfranked distributions paid
directly to foreign investors, consistent with the existing law and Australia's tax
treaties. No non-resident DWT would be paid on franked dividends.

Despite the similarities, taxing unfranked inter-entity distributions under
Recommendation 11.1 is less complex than the resident dividend withholding tax. Taxing
unfranked inter-entity distributions means that unfranked distributions to non-residents
will continue to have DWT applied directly to them (rather than the refund arrangements
that would be required with the resident dividend withholding tax to achieve the DWT
result). Also, under this approach withholding of tax from unfranked distributions to all
resident shareholders with associated reporting and advising arrangements is not required.
It also reduces the instances in which early refunds of imputation credits will be needed.
And tax is also not imposed on unfranked distributions paid directly to tax-exempt
entities. Overall, the recommended approach will involve less change from current
arrangements.

Relevant also were concerns that applying the resident dividend withholding tax on
certain trust distributions to the States may give rise to constitutional issues
associated with imposing tax in relation to property of any kind belonging to a State. The
taxation of trusts like companies is subject to the same limitations. However, these
constitutional limitations depend on the particular nature of a State's interest in the
trust property.

The main disadvantage of the recommended option is that it retains the need for the
provisions relating to the determination of franked and unfranked dividends. It has less
inherent integrity than resident dividend withholding tax because tax applies to the
receiver of dividends rather than the payer. As well, an ongoing opportunity remains for
dividend streaming (but this also exists under resident dividend withholding tax). Under
unified entity taxation, these disadvantages that apply in relation to companies will
carry over in the application of the company tax arrangements to trusts. These
disadvantages are not judged to be as serious as those that would flow from a deferred
company tax with its effects on the reported profits of companies and the taxation of
non-resident non-portfolio investors.

Along with the discussion of options to achieve integrity through the entity chain, the
potential for double taxation of distributed tax-preferred income caused by temporary tax
preferences is discussed in A Platform For Consultation (Chapter 15,
pages 355-360).

This level of taxation arises under the existing law and the issue will remain under
any of the three options for improving integrity through the entity chain. However, the
deferred company tax option highlights the potential double tax issue because the double
tax liability would fall on the paying entity. Under the existing law and the other two
options, the second level of liability would fall on the investor. Without deferred
company tax there is less need to address this issue.

None of the solutions proposed in A Platform for Consultation is entirely
satisfactory from a complexity, compliance cost and revenue perspective. However, in a
practical sense, entities usually have sufficient control over their distributions to
mitigate the tax at the shareholder level.

The issue is, as noted, a feature of the existing law and has not been raised in the
consultation process, except in the context of a deferred company tax, where clearly there
is no separation in the incidence and the duplication is readily apparent.

The consistent entity tax arrangements (including the taxing of trusts and
co-operatives like companies) will mean that distributions to and from these entities will
also be subject to the imputation system. Therefore, unfranked distributions received by
these entities will be subject to Recommendation 11.1.

Taxing trusts like companies will also mean non-residents investing in trusts will be
taxed at the company tax rate rather than the relevant withholding tax rate on
distribution. In particular, interest derived by a trust and distributed to a non-resident
beneficiary will be taxed at the company tax rate rather than being subject to interest
withholding tax. However, this impact of the entity treatment will not affect trusts that
are eligible for the flow through treatment of collective investment vehicles (see
Recommendation 16.1).

That entity tax paid on unfranked non-portfolio distributions received
by a resident entity that is 100 per cent owned by a non-resident be refunded,
but only when the distribution is paid to the non-resident and the non-resident is subject
to DWT.

In A Platform for Consultation (page 352), the Review canvassed the option of
relieving foreign investors from the tax on unfranked inter-entity distributions and
applying DWT -- in order to achieve the same outcome as now when distributions out of
untaxed profits pass through the company chain before going to non-residents.

Providing a refund to non-residents of all tax on unfranked inter-entity distributions
would involve significant complexity -- requiring an additional franking account and
related franking rules to track the tax on unfranked distributions though an entity chain.
In certain circumstances, income tax on unfranked inter-entity distributions that
eventually flow to non-resident non-portfolio investors would significantly increase the
Australian tax on direct investment in Australia.

A particular concern is where non-residents invest in incorporated joint ventures in
Australia via a resident subsidiary or a consolidated group. Without the recommended
treatment, non-residents would be seriously disadvantaged if they invest via an
incorporated joint venture rather than via an unincorporated joint venture. The tax system
should not impose such an impediment in relation to transactions which are commercially
sensible and are often a feature of major projects.

This impact on direct investment will be avoided by a refund of tax on unfranked
inter-entity distributions where the entity (or consolidated group) paying the tax is 100
per cent owned by a non-resident and has itself a 10 per cent or greater
interest in the entity paying the distribution. The refund will be available to the
non-resident parent when a distribution is paid from Australia by the 100 per cent owned
entity. Concurrently, DWT will be levied -- ensuring that Australia receives the same
level of tax as currently (generally at a 15 per cent rate).

Such a refund will be relatively simple because it will be calculated from
distributions received and paid by eligible entities. Also, it will involve only a small
number of entities.

(a) That franked distributions by resident entities continue to be
exempt from DWT.

Company tax/DWT switch not adopted

(b) That no action be taken regarding a Non-Resident Investor Tax Credit
(NRITC) for portfolio non-resident shareholders.

DWT exemption for foreign pension funds exempt at home

(c) That the DWT exemption on unfranked distributions paid from
Australian resident companies to foreign pension funds exempt from tax in their own
jurisdiction, be retained.

The prevailing international practice for the treatment of portfolio dividends is for
these dividends to be subject to DWT at rates agreed between countries and reflected in
double taxation agreements (DTAs). Under the DTAs, investors receive a foreign tax credit
in their home country for the DWT imposed.

In A Platform for Consultation (pages 637-642), the Review discussed whether
Australian tax on franked portfolio dividends should be limited by continuing not to
impose DWT on them or by imposing DWT and refunding some company tax. Termed the
Non-Resident Investor Tax Credit (NRITC), the refund of company tax would have been
calculated so that it equalled the DWT imposed. Because taxable foreign portfolio
investors receive a foreign tax credit for DWT but do not receive a foreign tax credit for
company tax paid in Australia, they would benefit from such a `switch' between company tax
and DWT.

The NRITC would be a necessary mechanism in the event that deferred company tax were
chosen as the way of achieving integrity through the entity chain -- in order to
address the impact of deferred company tax on non-resident portfolio investors. As noted
under Recommendation 11.1, the NRITC is not necessary with the recommended taxation
of unfranked inter-entity distributions. Remaining at issue is whether to introduce the
NRITC, in any case, in order to increase the attractiveness of Australia as an investment
location for portfolio investors.

If all foreign portfolio investors were subject to DWT, the NRITC would not reduce
Australian revenue (as the reduced company tax is matched by increased DWT). Foreign
pension funds are, however, currently exempt from the DWT that applies to unfranked
dividends. If the partial refund of company tax were to be paid to non-resident investors
who are exempt from DWT, the effective tax rate applying to franked dividends would fall
from 36 per cent to 25 per cent -- or from 30 per cent, if that were the company
tax rate, to 18 per cent.

Thus, retaining the DWT exemption for foreign pension funds and introducing the NRITC
would cost about $190 million per annum if foreign pension funds provide 50 per cent of
portfolio investment (as suggested by the available information). With roughly equivalent
proportions of taxable and tax exempt foreign investors, the cost to Australian revenue of
providing the NRITC to the exempt foreign pension funds is equal to the increased
crediting of Australian DWT for taxable investors by other countries. Moreover, a refund
mechanism would be needed with the NRITC for foreign pension funds because of this tax
exempt status. This reform would be complex, involving companies and intermediaries (such
as nominee companies) administering the refund or providing information to the Australian
Taxation Office to allow it to make the refund.

If, instead, the foreign pension fund DWT exemption were to be removed, Australia's tax
on some unfranked dividends would increase from zero to 15 per cent. The small
proportion of portfolio dividends that are unfranked means that this impost is likely to
be small (less than $20 million). Moreover, it would be outweighed by the effect on
the foreign pension funds of any reduction in the company tax rate (roughly
$10 million per percentage point).

Nevertheless, removing the DWT exemption from foreign pension funds may be perceived as
increasing the tax burden on these investors and decreasing the attractiveness of
Australia as an investment location.

Because of the significant revenue cost, the complexity of the refund and some
uncertainty about the acceptability of the NRITC to other countries, the company tax/DWT
switch will not be adopted.

That the existing section 46 inter-corporate dividend rebate be replaced
with a gross-up and credit approach for preventing double tax on distributions passing
between resident entities (outside of consolidated groups).

Three options for preventing double tax on distributions as they pass through an entity
chain were canvassed in A Platform for Consultation (Chapter 17,
pages 390-398):

 gross-up and credit;

 exempt the franked portion of distributions received; and

 rebate franked inter-entity distributions (similar to the existing
section 46 inter-corporate dividend rebate, but only applying to the franked
portion of a distribution).

All the options prevent double tax through the entity chain. The exemption option is
not preferred because deductions would be denied for expenses incurred in deriving the
distribution (unless special measures were developed to prevent such an outcome).

The gross-up and credit approach is the same mechanism used to determine tax payable on
dividends received by individuals and superannuation funds. The taxable income of the
entity receiving a franked dividend is determined under this approach by adding the
imputation credit to the cash dividend received. Recommendation 11.4 will therefore
provide a simple and consistent treatment of distributions through the entity chain and
out to individual investors.

Losses in the entity chain are the source of the main difference between the gross-up
and credit approach and the alternative inter-entity rebate. Because of the grossing up of
the cash distribution by the attached imputation credit, the gross-up and credit approach
absorbs losses faster than the inter-entity distribution rebate. The rate of absorption
under the gross-up and credit approach will correspond to the reduction in the loss that
would occur if the income reducing the loss were earned directly by the entity with the
loss (rather than being received by that entity as a distribution via an interposed
entity). It is also the same reduction that would occur if an individual with a
carry-forward loss received the income directly or via a distribution.

Example 11.1 illustrates how losses are absorbed under the two approaches.

Example 11.1 Rate of loss absorption

To illustrate, an entity with a $100 loss could receive $100 income
directly or via another entity. If the income were received directly the loss would be
reduced by $100 to nil. If the income were received via another entity and taxed in that
other entity, the net distribution to the receiving entity would be $70.

 Under the gross-up and credit approach the
distribution will be grossed up to $100 so that the loss will be reduced by $100 to nil.
(The same reduction would occur to a $100 carry-forward loss of an individual receiving
the distribution.)

 The rebate option would reduce the loss of
the entity by only $70 - leaving a $30 loss to be carried forward.

This difference in the rate of absorption of losses under the two
approaches would equal out over time, as the entity with the loss earns income directly.
The $30 of extra loss to be carried forward under the rebate alternative would reduce the
company tax payable by the entity on that income. But those untaxed profits would be taxed
when ultimately distributed.

During consultation the main concern raised related to the rate of absorption of losses
through the entity chain. An alternative proposal was to allow a dividend-received
deduction similar to the deduction available under the US tax system. Such a
deduction would, however, effectively reverse the tax on unfranked inter-entity
distributions recommended earlier -- with the accompanying integrity problems of the
present arrangements.

The next recommendation on carry-forward losses is intended to alleviate most of the
concerns raised during consultation about the interaction of losses with the gross-up and
credit approach.

That entities (including consolidated groups) be able to choose the
proportion of their carry-forward losses to be deducted in a year.

During consultation two main concerns were raised about the effect of distributions on
losses.

 First, as noted in respect of Recommendation 11.4, concern was
raised about the rate of absorption of losses under the gross-up and credit approach for
preventing double tax through the entity chain.

 Second, concerns were raised that the proposed consolidation regime
would force groups to apply distributions received by them to losses earlier than under
the existing law. Currently, groups usually ensure that distributions from outside the
group are paid to the holding company with any losses held by subsidiaries. Under the
current loss transfer provisions, the holding company and subsidiary can agree on the
amount of loss to be transferred. This allows the holding company the option of not
absorbing group losses against distributions received by the holding company from outside
the group. The pooling of group losses under consolidation would remove this option in the
absence of a specific measure.

Both these concerns will be overcome by allowing entities (including consolidated
groups) to choose the proportion of carry-forward losses to be deducted in a year. Under
the current law, a company cannot choose the amount of carry-forward loss it wishes to
deduct. A company is forced to claim the amount of loss necessary to absorb the excess of
assessable income over allowable deductions. As noted, in contrast, under the existing
loss transfer provisions, groups can choose the proportion of loss to transfer within the
group.

The recommended measure will allow consolidated groups and single entities -- as
well as unconsolidated groups -- to avoid having a carry-forward loss absorbed by
grossed-up franked distributions received from other entities or groups. This will provide
consistency of treatment across these taxpayers. It also provides a mechanism for single
entities or groups to fully frank distributions of profit even when they have large
carry-forward losses. By not fully claiming the losses, the group or entity could pay
sufficient tax to frank the distributions.

Carry-forward losses will still have to be reduced by the amount of net exempt income
derived by an entity, consistent with the existing law.

This measure will not apply to individuals or complying superannuation funds. Unlike
entities, individuals and complying superannuation funds will not be affected by the
absorption of carry-forward losses by franked distributions received by them. The proposal
to refund excess imputation credits effectively gives these taxpayers the full benefit of
the losses immediately.

Under the current law, the franking account is operated on a taxed-income basis so that
the balance in the franking account reflects the amount of franked distributions able to
be paid. The difficulty with this approach is that it requires grossing up of most entries
to the franking account to reflect taxed income. The taxed-income basis also led to the
creation of the complex multiple franking accounts (the Class A, B and C franking
accounts) in response to company tax rate changes.

The recommended approach is to operate the account on a tax-paid basis so that grossing
up will not be required for most entries to the account. This approach will avoid further
proliferation of franking accounts as no adjustment will be made on change of the company
tax rate. However, on making a distribution, an entity will need to gross up the balance
in the franking account to determine the amount of franked distribution.

Because companies are now used to operating on a taxed-income basis, changing to a
tax-paid basis may inconvenience some companies. Nevertheless, other entities, such as
most trusts, will be using a franking account under the new entity system for the first
time. Consultation on this issue has supported the change to a tax-paid basis.

The second proposal, to align the income year and franking year, will correct an
anomaly in the existing law that some late balancing companies have a franking year which
is different from the income year. The current complexities will be removed for these
companies without affecting other entities.

The possibility of further simplifying the franking account by adopting a standard
annual franking allocation rule as under the New Zealand imputation system was raised in A
Platform for Consultation (page 389). This would be intended to limit the
opportunities for dividend streaming, but in a simpler manner. Under the recommendation,
which is a variant of the New Zealand approach, the existing complex franking rules will
be replaced with a requirement that entities adopt a standard rate of franking for all
distributions made during a half-year.

Features of this proposal include:

 entities, apart from widely held entities with a single class of
membership, identifying, prior to the first distribution in a half-year, a standard rate
of the franked portion of distributions to be made during the half-year;

 the standard rate applying to all distributions, irrespective of
class of membership, during that half-year; and

 entities being free to set any standard rate, but:

- if an entity overfranks it will have to pay franking deficit tax;

- the franking deficit tax will not be creditable against future income tax liability,
otherwise it would reinstate tax preferences and would be inappropriate in a system with
refundable imputation credits;

- entities will only be able to vary their standard rate in a half-year in exceptional
circumstances, and measures will be needed to prevent excessive variation of rates between
half-years, in order to limit opportunities for dividend streaming.

The measures will simplify the franking rules while reducing the opportunities for
dividend streaming. It will especially benefit widely held entities which have a single
class of membership interest because they will not be subject to franking restrictions. It
will also provide all entities with the ability to introduce more certainty in franking
policy over a number of years. The main concern is that it effectively locks entities into
a rate of franking irrespective of what happens during the half-year. This is partly
overcome by the fact that many entities, especially the large corporates, will only
distribute once in a half-year. Furthermore, widely held entities that have a single class
of membership will be free to vary their franking rate between distributions within a
half-year if, for each of those distributions, the entity makes equal distributions on all
membership interests.

(a) That refunds of excess imputation credits be provided to resident
individuals and complying superannuation entities.

Early refunds of excess credits in certain circumstances

(b) That in respect of closely held trusts, closely held companies and
all co-operatives, arrangements be made to enable low marginal rate individual investors
to obtain early refunds of excess imputation credits.

(c) That the early refunds be provided via the distributing entity at
the time of distribution.

Refunds related to donations to registered charities

(d) That refunds of excess imputation credits not be extended to
tax-exempt entities other than imputation credits attached to `donations' to registered
charities by way of trust distributions.

In A New Tax System, the Government proposed refunds of excess imputation
credits for resident individuals and complying superannuation funds. The Review supports
this measure, which will ensure that such taxpayers are taxed at their appropriate
marginal rates of tax on assessment.

It was recognised in A New Tax System (Chapter 3, page 118) that
consistent entity tax arrangements (including the taxing of trusts and co-operatives like
companies) which incorporated full franking of distributions may impose adverse cash flow
consequences on low marginal rate taxpayers despite the availability of refunds of excess
imputation credits on assessment.

In contrast with the universal `full franking' effect of the deferred company tax
canvassed in A New Tax System, the Review has recommended taxing unfranked
inter-entity distributions (see Recommendation 11.1). This will mean that entities
will be able to continue to distribute tax-preferred income earned in the entity as
unfranked distributions. To some extent this lessens the cash flow impact on low marginal
rate investors who receive unfranked distributions.

The Review also recommends (see Section 16) flow-through treatment of collective
investment vehicles (CIVs), rather than including CIVs in the entity tax arrangements (see
Recommendation 16.2). This will remove the potential cash flow impact on low marginal
rate trust beneficiaries who derive their income largely from CIVs.

Investors in widely held entities are unlikely to suffer a cash flow disadvantage from
the proposed entity taxation arrangements. Shareholders in companies will benefit from the
refundability of excess imputation credits relative to the current law, and unitholders in
CIVs will enjoy flow-through treatment.

Nevertheless, beneficiaries of some trusts will face adverse cash flow consequences
from the taxation of trusts like companies. This is a particular issue for small
businesses, and underlines the case for provision of early refunds to individual investors
in closely held entities. In contrast with the high compliance costs for widely held
businesses of providing an early refund mechanism, closely held entities have a greater
ability to control the timing and amount of distributions, thereby facilitating an early
refund mechanism where entity tax is paid.

Members of co-operatives, including widely held co-operatives, may also suffer cash
flow disadvantages. Often the co-operative members will sell their produce to the
co-operative for a price below the market rate, with the balance arriving via a
co-operative distribution. Therefore, the distributions may be more significant than a
distribution from other widely held entities.

The flow-through taxation of CIVs, the receipt of unfranked distributions, and the
virtual pooled superannuation trust treatment for life companies address the cash flow
issue for complying superannuation funds. The Review therefore does not recommend
extending the early refund mechanism to complying superannuation funds. Refunds to such
funds will of course still be available on assessment.

Two possible approaches of providing early refunds of excess imputation credits are
canvassed in A Platform for Consultation (Chapter 15, pages 363-366):

 providing a refund at the entity level so that distributions to
eligible beneficiaries are gross of company tax; or

 allowing an option for refundable credits to be claimed through
instalments during the course of the income year.

The recommended option is to require closely held entities (defined in
Recommendation 6.22) and all co-operatives to provide refunds at the entity level.
This is the best option for the taxpayer entitled to a refund, because there is no double
handling or time delay between the receipt of the distribution and the refund. It also
obviates the need for non-lodging investors to lodge a return just to obtain the refund.

The mechanism for providing the refund at the entity level will include the following
requirements:

 an eligible member notifying the distributing entity of their
election to obtain early refunds of excess imputation credits, as well as a selected rate
of `withholding', chosen from a range of rates (for example, 0, 5, 10, 15, 20 or 25 per
cent);

 the distributing entity effecting early refunds to those members by
paying distributions gross of entity tax, but not of the selected withholding rate, to
those members;

 the distributing entity reducing its net PAYG payments to take
account of the early refunds of excess imputation credits made to its members;

 advice for members still to show the franked portion of the
distribution to facilitate assessment where necessary; and

 members receiving early refunds will not have to lodge returns
simply because of the receipt of the refund, unless, as now, their income level requires
lodgement.

Those taxpayers who have not accessed early refunds will still be able to receive the
refund on assessment.

During consultation a number of submissions sought refunds of excess imputation credits
for all or some tax exempts. In A Platform for Consultation (Chapter 15,
pages 362-363), it was explained that in A New Tax System the Government
proposed a refund of imputation credits for tax paid at the trust level on `donations' to
registered charities by way of trust distributions. The Review recommends that approach,
which will maintain the current net tax position of such donations.

That subject to Recommendation 11.9, the entity tax arrangements apply
to all entities from the same date.

The entity tax system is intended to apply from a particular income year. Most entities
have an income year that corresponds with the usual financial year commencing on
1 July.

For early balancing entities, applying the regime from the beginning of their 2000-01
income year could potentially mean that they would have little or no notice of all the
details of the legislation covering the entity tax system prior to that time.

A common start date avoids these problems, but involves additional complexity in the
legislation and associated higher compliance costs for entities with early and late
balancing dates. Such entities may have to prepare two separate tax calculations for the
affected income year so as to cover the different arrangements applying to the periods
before and after 1 July.

Notwithstanding this disadvantage, consultations have indicated support for a common
start date.

The removal of accelerated depreciation, and other reforms to the business income tax
system, provide scope within the revenue neutrality constraint to reduce the company tax
rate to 30 per cent from the 2001-02 income year. That constraint will provide for a 34
per cent rate for the 2000-01 income year, but with no variation in instalments permitted
before 1 July 2000. Revenue neutrality aside, the 30 per cent rate has
structural advantages as it will align the company tax rate with the 30 per cent
marginal tax rate applicable to most individual taxpayers.

Moreover, a 30 per cent tax rate will make the headline rate of corporate tax
internationally competitive, both in terms of the Asia Pacific region and compared with
the corporate tax rate operating in capital exporting countries.

By providing a competitive corporate tax rate, non-portfolio foreign investors in
Australian companies can benefit because they will be better placed to utilise foreign tax
credits available in their home jurisdictions -- reducing the possibility of foreign
tax credits being lost because the Australian tax rate is higher than their home country
rates. For portfolio investors who receive no credit in their home country for underlying
company tax, reducing the tax rate directly increases their after-tax return from
investing in Australian stocks. More generally, a low company tax rate is a strong signal
to the foreign investor, especially if accompanied by a clear and user friendly tax
system.

By increasing Australia's attractiveness as an investment location, a lower company tax
rate strengthens Australia's prospects for investment, economic growth and jobs. Crucial
to this are the accompanying reforms to the business investment base because they will
attract investment to where it will be most productive, not where a faulty tax system
channels it. The strength of Australia's commercial base and the long-run growth potential
of Australia are bolstered as a result.

Reducing the corporate tax rate will also enable Australian companies to maintain
dividend flows to shareholders while increasing the levels of retained income and
investment.